Saturday 3 November 2001 19.00 EST
First published on Saturday 3 November 2001 19.00 EST

With-profits: the very name sounds solid and dependable - you can almost picture those profits stacking up in your pension pot. Unfortunately, as recent events have shown, the image does not always live up to the reality.

Ask anyone who holds such a policy with Equitable Life or who is hoping that a with-profits endowment will repay their mortgage. Millions will tell you that 'without-profits' would be a better description.

But do these disasters spell the end for with-profits policies as a means of saving for retirement? Or are they specific problems which have no bearing on the attractions of with-profits generally?

The growing number of detractors say that with-profits policies are hard to understand, perform badly and are expensive. The supporters - who naturally include the firms promoting them - say the current turbulent stock markets will underline their attractions as a relatively safe investment vehicle.

The principle sounds attractive enough. While other investment products rise and fall in line with stock market performance, with-profits policies aim to provide a smoothed return: growth will be lower than the rest of the stock market when share prices are roaring ahead, but the compensation is protection from sharp falls when, as in the past couple of years, markets drop. The smoothing is done through bonus payments: these are paid annually, based on the performance of the fund over the previous year, and a terminal bonus when the policy matures, based on performance over its lifetime.

But these very attractions provide ammunition for the critics. The Consumers' Association, which is campaigning for improvements in the way with-profits policies are managed, complains that smoothing simply makes these policies difficult to understand and to value. It complains that annual bonuses are only loosely linked to investment performance, if at all. There are no clear rules about how they should be calculated, merely a vague requirement to have regard to 'policyholders' reasonable expectations' - whatever those might be.

And it says that terminal bonuses - where the amount is even more uncertain - are becoming worth as much as two-thirds of the final value of the policy. That means it is hard for any policy holder to work out what their policy is worth now, never mind its value when they retire.

Too often, however, there is little point in getting out. For many policies, the charges are imposed in the first few years, so cashing in early may mean getting back less than you have put in. Yet the association estimates that 40 per cent of personal pensions lapse or are transferred in the first four months, usually producing negative returns for their holders.

More recently, yet another disincentive to transfer has been introduced - the market value adjustment. This is the amount by which the fund manager will reduce the value of your pension pot if you want to transfer it, to reflect uncertain market conditions. Most famously used by Equitable Life - which has set its MVA at a swingeing 10 per cent - many other firms, including Legal & General and Friends Provident, are also imposing the reduction.

Most firms that manage with-profits policies admit that some of these criticisms are justified but say they are getting better. John Hylands, general manager, marketing, at Standard Life, which has a third of its business in with-profits funds, says of bonus declarations: 'We are not robbing one to pay the other. It is a question of redistributing the peaks and troughs. Our customers are prepared to give up some of the upside in return for protection against the downside.' He believes the returns on these policies is in line with returns on equities.

He adds that protection against market fluctuations is important when share prices are falling. While someone with a unit-linked policy retiring at the end of September could have been badly hit by the collapse in stock markets in the aftermath of the US attacks, a with-profits policy holder would have been unaffected as his bonuses would have been locked in.

Hylands says Standard is now more open about returns, what the charges are, and is finally telling holders exactly what their policy is worth. But others have done far less. There is still some way to go to improve the image of with-profits funds.